Is our new easy-to-use stock valuation program that interacts with our online valuation service. Now you can download data from our web site to your computer and use ValuePro to analyze your investments. The price is only $44.95. Please see our Guide to the ValuePro Software for an in-depth description. Try our online stock valuation service. Enter the stock symbol, click on the Get Baseline Valuation button, and we do the rest. The inputs used to value the stock are updated periodically. You can change any input and recalculate a stock value. Learn more about using the online valuation by clicking here. Enter Stock Symbol:ValuePro
We are developing a stock value/stock price screening program which will rank stocks based upon a value-to-price ratio and a portfolio valuation program. ValuePro.net was founded by three financial engineers/finance professors to develop and distribute inexpensive, easy to use and understand valuation tools.
The ValuePro approach uses a discounted cash flow (DCF) technique to value common stock. DCF techniques are used by investment bankers for merger and acquisition analysis, Wall Street traders to value all types of debt obligations, and Wall Street analysts to value stock.
Step 1—Forecast Expected Cash Flow: the first order of business is to forecast the expected cash flow for the company based on assumptions regarding the company's revenue growth rate, net operating profit margin, income tax rate, fixed investment requirement, and incremental working capital requirement. We describe these variables and how to estimate them in other screens.
Step 2—Estimate the Discount Rate: the next order of business is to estimate the company's weighted average cost of capital (WACC), which is the discount rate that's used in the valuation process. We describe how to do this using easily observable inputs in other screens.
Step 3—Calculate the Value of the Corporation: the company's WACC is then used to discount the expected cash flows during the Excess Return Period to get the corporation's Cash Flow from Operations. We also use the WACC to calculate the company's Residual Value. To that we add the value of Short-Term Assets on hand to get the Corporate Value.
Step 4—Calculate Intrinsic Stock Value: we then subtract the values of the company's liabilities—debt, preferred stock, and other short-term liabilities to get Value to Common Equity, divide that amount by the amount of stock outstanding to get the per share intrinsic stock value.
How does a corporation make money? It makes money by operating business lines where it manufactures products or provides services. A company generates revenue by selling its products and services to another party. In generating revenue, a company incurs expenses—salaries, cost of goods sold (CGS), selling and general administrative expenses (SGA), research and development (R&D). The difference between operating revenue and operating expense is Operating Income or Net Operating Profit.
To produce revenue a firm not only incurs operating expenses, but it also must invest money in real estate, buildings and equipment, and in working capital to support its business activities. Also, the corporation must pay income taxes on its earnings. The amount of cash that's left over after the payment of these investments and taxes is known as Free Cash Flow to the Firm (FCFF).
FCFF is an important measure to stockholders. This is the cash that is left over after the payment of all cash expenses and operating investment required by the firm. It is the hard cash that is available to pay the company's various claim holders, especially the good guys—the stockholders! The simple equation used to calculate FCFF is:
FCFF = NOP – Taxes – Net Investment – Net Change in Working Capital
There are five key cash flow measures that are important in estimating the free cash flow to the firm that is used in the DCF approach. Those five cash flow measures, which we have called 'The Five Chinese Brothers' (named after a famous folk tale) are: the revenue growth rate, the net operating profit margin, the company's income tax rate, net fixed capital investment rate, and incremental working capital investment rate.
The revenue growth rate is equal to your estimate of the firm's revenue growth rate in percent over the Excess Return Period. Finance Internet sites like Zack's, First Call, and IBES project revenue growth rates over differing periods. Yahoo Finance and America Online also have growth rates. Warning: Academic studies have shown that analyst's forecasted growth rates have been upwardly biased.
Net operating profit margin is equal to a firm's operating profits divided by its revenues. A firm's income tax rate is equal to the provision for income taxes divided by the firm's operating income before provision for taxes. The information necessary to compute NOPM and income tax rate can be found on the firm's income statement as part of its annual or quarterly reports.
Net fixed investment rate is equal to the company's new investment in plant, property and equipment (PP&E) minus depreciation charges taken. To calculate this ratio, you need to know the company's investment rate, equal to the firm's yearly investment in PP&E divided by revenues, and the company's depreciation rate, equal to the firm's depreciation charges divided by revenues. The firm's investment in PP&L and depreciation charges can be found on its cash flow statement in its annual report.
Incremental working capital investment rate is equal to the change in working capital divided by the change in revenue. Working capital is equal to [( Accounts Receivable + Inventory) – Accounts Payable]. The firm's accounts payable, inventories, and accounts receivable can be found on its annual balance sheet in its annual report.
The free cash flow to the firm approach provides for several distinct time periods for estimating cash flow which allow differing value-creating periods for a corporation's business strategy. In the Excess Return Period, because of a competitive advantage that the firm has, the corporation is able to earn returns on new investments that are greater than its cost of capital. Classic examples of companies that experienced a significant period of competitive advantage are IBM in the 1950's and 1960's, Apple Computer in the 1980's, and Microsoft and Intel in the 1990's.
Success invariably attracts competitors whose aggressive practices cut into market share and revenue growth rates, and whose pricing and marketing activities drive down net operating profit margins. A reduction in NOPM drives return on new investment to levels that approach the corporation's WACC. When a company loses its competitive advantage and the return from its new investments just equals its WACC, the corporation is investing in business strategies in which the aggregate net present value is zero (or worse yet, negative—witness IBM in the 1980's and Apple in the 1990's).
The length of the Excess Return Period for the corporation will depend on the particular products being produced, the industry in which the company operates, and the barriers for competitors to enter the business. Products that have a very high barrier to entry due to patent protection, strong brand names, or unique marketing channels might have a long Excess Return Period (10 to 15 years or longer). The Excess Return Period for most companies is 5 to 7 years or shorter. All else equal, a shorter Excess Return Period results in a lower stock value.
What do you use as an input for the Excess Return Period? This is your judgment call when valuing a stock. We use what we call the 1-5-7-10 RULE.
A firm's weighted average cost of capital (WACC) is a difficult concept to understand. It may be helpful to think of a company's WACC in relation to the weighted average return on your own investment portfolio. You may own $10,000 in a money market fund that has an expected yearly return of 6%. You also may own $10,000 of a preferred stock with an expected return of 8%. And you also may own $80,000 market value of a common stock with an expected return of 10%. The expected weighted average return of your $100,000 (in total) investment portfolio equals:
Exp. Port. = ($10,000 x .06) + ($10,000 x .08) + ($80,000 x .10) = $9,400 = 9.4% Return ($100,000) $100,000
A company's WACC is very similar to your investment portfolio's weighted average return as described above. It's simply the weighted average expected cost for the company's various types of obligations—debt, preferred stock, and common stock—that are issued by the corporation to finance its operations and investments.
The company's WACC is a very important number, both to the stock market for stock valuation purposes and to the company's management for capital budgeting purposes. In an analysis of a potential investment by the company, investment projects that have an expected return that is greater than the company's WACC will generate additional free cash flow and will create positive net present value for stock owners. These corporate investments should result in an increase in stock prices.
These projects are good things! Investments that earn less than the firm's WACC will result in a decrease in stockholder value and should be avoided by the company.
Where are the best places to go on the Internet to get the information that you need to value stocks and use the ValuePro Program? Our web site with its online valuation service is a good place to start.
When you value a stock of a company, the next place that you should visit for information is the company's own corporate Web site. At this site you can get the corporation's Annual Report, which contains its Income Statement, Balance Sheet, and Cash Flow Statement, and its most recent quarterly earnings release. This will provide you with the bulk of the information that you need for valuing its stock.
The next set of sites that you should visit are Internet sites devoted to investment information. Some sites are free or partly-free and some provide information to subscribers only. Good sites to get corporate betas and growth rates are America Online, Microsoft Investor, S&P Personal Wealth and Yahoo Finance. At most of these sites, either Zack's, First Call, or IBES act as the source of growth rate data.
Warning: Academic studies have shown that analyst's forecasted growth rates have been upwardly biased.
Yahoo, AOL, MSN, Market Guide, Hoover's and Bloomberg Finance, among others, act as good sites to get valuation inputs relating to cost of capital, such as the risk-free Treasury yields, rates associated with preferred stock and corporate debt, shares outstanding, and current stock prices.
About the Software
The ValuePro Program is an integrated program that consists of five screens: two input screens—the General Input Screen and the Custom Input Screen; and three output screens—the Weighted Average Cost of Capital Screen, the General Pro Forma Screen, and the Custom Pro Forma Screen.
The General Input Screen is the initial screen of the ValuePro Program. Here you insert the initial cash flow and cost of capital inputs. Given the initial inputs, this screen will calculate Intrinsic Stock Value based only on those initial inputs.
The Weighted Average Cost of Capital (WACC) Screen is the first output screen of the ValuePro Program that shows, based on the general inputs, the calculation of the after-tax weighted average cost of capital, and the market capitalization of the company that you are valuing.
The General Pro Forma Screen is the output screen of the ValuePro Program that shows, based on the general inputs, the calculation of free cash flow over the Excess Return Period, the Total Corporate Value of the firm, the Total Value to Common Equity, and the Intrinsic Stock Value.
The Custom Input Screen is the input screen of the ValuePro Program on which you can change any one of six cash flow measures and the weighted average cost of capital for any year during the Excess Return Period.
Custom Pro Forma Screen is the output screen of the ValuePro Program that shows, based on the custom inputs, the calculation of free cash flow over the Excess Return Period, the Total Corporate Value of the firm, the Total Value to Common Equity, and the Intrinsic Stock Value.
Navigating the ValuePro Program
On the Toolbar of the ValuePro Program there is a 'ValuePro' function. When you click on that function, a pop-up menu for the five ValuePro screens will appear. Click on the name of the ValuePro screen that you wish to go to and you will be taken there immediately.
We group companies into one of four general categories and Excess Return Periods: (1) the boring companies that operate in a competitive, low-margin industry in which they have nothing particular going for them—a 1-year Excess Return Period; (2) the decent companies that have a recognizable name and decent reputation and perhaps a regulatory benefit (e.g. Consolidated Edison)—a 5-year Excess Return Period; (3) the large, economies of scale good companies with good brand names, marketing channels, and consumer identification (e.g. McDonald's and AT&T)—a 7-year Excess Return Period; and (4) the knock-em-dead great companies with tremendous marketing power, brand names, and in-place benefits (e.g. Intel, Microsoft, Coca Cola and Disney)—a 10-year Excess Return Period.
We do not believe in going out more than 10-years with an Excess Return Period. Some fundamental stock valuation models, like the dividend discount model, incorporate earnings and dividend growth in excess of the company's WACC, out to an infinite time period. Cash flow in these models is discounted until the 'hereafter'.
We think that 10 years is a reasonable amount of time to incorporate the product cycles of today's markets.
What happens after the Excess Return Period? Does the company dry up, die, or go bankrupt? NO! For valuation purposes, the company loses its competitive advantage. This loss of competitive advantage means that the company's stock value will grow only at the market's required rate of return for the stock. For example, if the common stock price of XYZ Boring Company (which does not pay dividends) is $20, and its required rate of return is 12%, its stockholders expect it to grow to ($20 * 1.12) = $22.40 after year 1, ($22.40 * 1.12) = $25.08 after year 2, and ($25.08 * 1.12) = $28.06 after year 3. After year 3, in this example, the company should pay all of its free cash flow to stockholders through dividends or share repurchases.
The annual rate of return that an investor expects to earn when investing in shares of a company is known as the cost of common equity. That return is composed of the dividends paid on the shares and any increase (or decrease) in the market value of the shares. For example, if an investor expects a 10% return from McDonald's stock and she buys a share at $67.25, her expectation is to receive $6.72 during the year through a combination of dividends (currently $.34 per share during 1998) and the appreciation of the stock price (presumed to be $6.38 to give her the 10%expected return totaling $6.72) during the year.
Let's now take a look at what rate of return, in general, an investor should expect from a stock. The return expected of any risky common stock should be composed of at least three different return components: (1) a return commensurate with a risk-free security (Rf); (2) a return that incorporates the market risk associated with common stocks as a whole (Rm); and (3) a return that incorporates the business and financial risks specific to the stock of the company itself, known as the company's beta.
The first measure of return (Rf) relates to what market rate of return is currently available from a risk-free security, like the yield associated with a long-term Treasury Bond. So if the yield on Treasury Bonds is 5%, an investor should expect a return greater than 5% for a common stock.
The second measure of return (Rm) relates to what market returns are currently available from and what risks are associated with stocks in general. There is a general risk premium (the equity risk premium) associated with the stock market as a whole. That risk premium should be priced into any equity investment. For example, if you expect to earn 8% on average (from a diversified portfolio) in the stock market and the risk-free rate is 5%, the Equity Risk Premium (Rerp) would be (Rerp) = (8% - 5%)= 3%.
Equity Risk Premium(Rerp) = Exp. Return on Market(Rm) - Risk Free Rate(Rf)
The third measure of return versus risk (beta) should be related to the specific stock being purchased—how risky is the type of business the firm does and how risky is the financial structure or leverage of the firm. Beta measures the risk of the company relative to the risk of the stock market in general. With greater risk, as measured by a larger variability of returns (business or operating risk), the company's should have a larger beta. And with greater leverage (higher debt to value ratio) increasing financial risk, the company's stock should also have a larger beta. And with a larger beta, an investor should expect a greater return. The beta of an average risk firm in the stock market is 1.00.
The financial risk model that uses beta as its sole measure of risk ( a single factor model) is called the Capital Asset Pricing Model (CAPM) and is used by many market analysts in their valuation process. The relationship between risk and return that comes out of that model and the one that is incorporated into our FCFF analysis and spreadsheet software is:
Exp.(Rs) = (Rf) + beta(Rerp)
which in English translates to "The expected return on a stock (e.g. McDonald's) is equal to the risk free rate (e.g. 5%) plus the specific stock's beta (e.g. 0.97) times the equity risk premium (e.g. 3.0%)." In numbers it looks like this: Expected Return on McDonald's Stock = 5% + 0.97(3.0%) = 7.91%
We always prefer to buy a stock that is priced below or near its intrinsic value. We do not buy a stock that is trading at a price that we believe is above its value. We understand the 'momentum trading approach' and know that when the stock market is bullish and a stock's trend is up, the trend can carry an 'overvalued' stock even higher. This occurs especially with a hot, growth industry like the Internet and with a stock that has a relatively small amount of shares available for trading.
We strongly believe that there is value to careful stock selection and also believe that an investor should own a diversified portfolio of common stocks. Within that portfolio the investor should value each stock individually using the DCF valuation technique. When the stock is 'overvalued' and it exceeds its intrinsic value by more than X% (the investor should pick that percentage, e.g. 15%), he should sell that stock and replace it with another stock that is 'undervalued' by more than X% (e.g. 15%).
The value of any asset is equal to the expected cash flows of the asset, discounted for timing and risk. Future cash flows for common stock can come from dividends, from the sale or merger of the company (e.g. AOL's merger with Time Warner), from the repurchase of the stock by the company (e.g. Microsoft and Intel have large share repurchase programs), or from the sale of the stock at market prices.
Select from the menu at left for a description of the DCF valuation approach or the ValuePro program.